Why contrarian value investing is both agony and ecstasy

Back in 1939 an investor called John Templeton made an unusual series of investments that eventually helped cement his reputation as a legendary contrarian. As America was emerging from 10 years of the Great Depression, Templeton (who was only in his late twenties at the time) sensed an opportunity.

He bought $100 of every stock trading below $1 on the New York and American stock exchanges - paying around $10,400 for stakes in 104 companies. Four years later, 34 of those companies had gone bust but Templeton had still made four times his money.

He went on to build a fortune by looking almost anywhere in the world to find contrarian value investments. It was summed up in one of his best known quotes:

“Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

What it takes to be a contrarian

Contrarianism lies at the heart of value investing. It’s the essence of going against the herd and taking psychologically-difficult decisions to buy stocks that most of the rest of us won’t touch.

These are the investors who are prepared to buy when others are nervous or fearful. They target unloved and distressed companies, and they can be some of the earliest movers when markets hit rock bottom. It was contrarians who made serious money in the early months and years of recovery after the dotcom crash and the financial crisis.

Evidence shows that human nature is likely to have us running for cover in the face of danger. That’s why contrarianism is so counter-intuitive to many investors, even though it can work well over time. Seth Klarman, a dyed in the wool billionaire value investor, made this point in his book, Margin of Safety. In it, he wrote:

“Value investing by its very nature is contrarian… Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period.”

But while - as Klarman point out - being a value contrarian can be…

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A lot of this is dependent on the size of the portfolio under management. Huge gains are *relatively* easy for small portfolios as defined by their absolute value. As the portfolio grows it becomes harder and harder to add incremental value, even for the very best. Peter Lynch, for example, had an outstanding record but by the end of his tenure the Magellan Fund had grown to such a size it was harder and harder to outperform. Warren Buffett has, by his own admission, a similar issue.

Realistically a 10% annual compound gain, adjusted for inflation, over 20 years+ will provide outstanding returns. People who can achieve better than that, regardless of what system they're using, are among the very best investors. 20%+ over that kind of period isn't realistic in the real world unless the starting amount is trivially small, and even then would be surprising.

The other thing to remember is that the investment world isn't static - the invisible hand applies to investing, too. So if someone comes up with a repeatable method that generates above average returns - Stockranks, say - and this becomes widely known, others will move to copy it and start to arbitrage away the returns. This has been seen repeatedly - the accrued interest anomaly is one instance that comes to mind.

In essence, the only thing that matters is real value in real portfolios over significant periods of time, which is why we all love Buffett and Munger so much. Even then there's an argument that after 1000 rounds of tossing coins there'll still be one lucky tosser coming up heads every time. Like all such arguments it's baloney, but it keeps believers in truly Efficient Markets sane at night :)

My strategy is just over 5 years old and it was simple to develop.I scrolled through the Guru screens ranked by 5 year performance until I found a strategy with a limited drawdown that generated a reasonable amount of stocks.

That screen formed the genesis of my strategy. Robbie Burns even publishes his trades and still people prefer to plough their own furrow thinking they can do better. His transparency inspired me to be transparent in my purchases using a fantasy fund.

I'm not sure what constitutes trivially small, but last year was my best year to date and I was close to my first ever six figure yearly gain, so I'm not managing £m's but it is far from a trivial amount of money.

Why? It's just capitalism at work - if something works and makes money and is publicised people will copy it and improve it and the margins will reduce. There's a small industry in academia and hedge funds doing nothing else.

As for the Naked Trader screen - well, yes, at any point in time it'll be possible to identify successful strategies with hindsight. That chart is over a 5 year bull market - any old idiot has been able to make money over that period. And believe me, I should know :)

What matters is why it's outperformed, because if it's not based on some underlying market anomaly or information asymmetry it's just noise in the machine and doesn't say anything about the period that really matters - the future. Correlation is not causality, otherwise the price of Bangladeshi butter would have been the best predictor of the S&P500 back in the day.

The point about the portfolio size also isn't about past performance, it's about the effect of the law of large numbers as compounded gains kick in. If I take your figures and round roughly for simplicity's sake it would suggest a £500K starting portfolio to get a six figure gain on a 26% uplift last year. If you compound that up over 20 years you end up with about £85 million, even without reinvesting dividends.

That would be nice, but it would make the investor one of the most successful of all time. Even Warren Buffett and Charlie Munger have only managed 19.1% over Berkshire Hathaway's lifetime in their control.

There's nothing wrong in riding the bull while it's storming ahead, but the real trick is in knowing when to get off.

Well I think the NT strategy and my approached that has developd from it is based on well known market anamolies ...

- Small cap investing
- Earning Surprises
- Momentum based approaches

I'd say it has a lot going for it and that's why it works so well. If it stops generating options in the UK, then I get options from the US & Europe.

Back to people cottoning on to a strategy ...

I'd suggest that the majority of people here would be delighted if their strategy grew their investments to £1m over time. No fund managers or financial academics are going to be paying attention to Joe Bloggs fantasy fund.

With respect the to NT screen and hindsight. There is no guarantee it'll continue to perform and when it doesn't I'll undertake the same exercise. Scan the Guru screens and see what's performing. Who says one has to be wedded to an approach?

Years ago here I was told "The market conditions will change and that strategy won't work any more".
I'm still waiting!

Yeah, might be. I stuck £500K and 26% into an online monthly compound interest calculator and that's what it threw out :)

We're in a highly unusual period for the markets, but history tells us that this period of relative calm won't continue forever. People get lax about risk management (aka disaster myopia) and don't see the issues coming. I'm not complaining, though, long may it continue!

Hi Tim, I don't follow some of that. If something works then why will it fail if more people follow it, you could argue that it will work better as more people are buying those shares. I have such comments about The Naked Trader, he has a lot of followers so the share price goes up after he announces his buys, same with Minervini. The Naked Trader screen has performed well, not the best but certainly much better than the market average and better than most other screens, it's not about making money, it's about how much money. The thing is there are so many different screens and other things on Stockopedia that no one screen or NAPs or whatever will have a huge following, even doing a NAPs the next day you will get a completely different selection. Also so many negative people who don't believe it will work for much longer etc. Yes it's been a bull market but Phils fund has made 225% in the last 5 years, the FTSE350 has made only 25.8% and the Allshare about 30%. Berthshire Harthaway made most of their money in the late 70-90s, I have seen some posts saying they don't beat the market average anymore, how much have they made over the last 10 or 20 years? How much has Mark Minervini made? If you are talking about funds, I would agree they get too large and difficult to manage, this is where the private investor has an advantage, he can buy and sell quickly as long he is in fairly liquid stocks at modest amounts. I agree the market won't go on up forever and will fall back but it does not follow that you can't still beat the market average. If you only have about 20 shares you can sell them and you can short the market etc. WB does not try to time the market although I have read he has a lot in cash at the moment.

Well, the problem tends to be that if there is some underlying market anomaly then the effect of everyone trading it will tend to arbitrage it away. An anomaly essentially just means predictable mispricing. Obviously if more and more people are trading this the price differential will disappear rapidly - it then becomes an arm's race as to who can get to the trade first, a situation that will always favour institutions with deep pockets.

With a lot of the more popular writers and tipsters you have to be quite careful about how you measure. The fact that a tip can move the market gives a tipster an inbuilt bias in their favour and they very often have better data sources than the average private investor. To be honest, I often wonder why they're writing about their strategies. Surely if they were any good they'd be trading and not telling anyone? Perhaps I'm just an old cynic ...

In terms of performance the starting value makes a huge difference, If my starting capital is £10,000 then a 225% gain is irrelevant in the bigger picture. If it's £1,000,000 then that's quite impressive. To be clear, I'm not commenting on Phil's fund, I'm just making a general point, it's a lot easier to outperform with smaller amounts of capital. That's the main reason Berkshire Hathaway's performance has tailed off a bit - it's not that Buffett and Munger are worse investors than they used to be, it's simply that when you have billion dollars to invest there aren't many things to put it in. They still managed 23% last year, mind you.

And the market matters - in a bull market it's not that difficult to make money, in a bear market it's incredibly hard and psychologically punishing. In 2007/8 I was 42% down at one point and it was sheer pain as I watched my life savings draining away day after day after day. At the time I was posting on TMF and the board traffic dropped to near zero as all the happy investors disappeared, one by one.

Basically if people are still posting about their great performance 18 months into the next bear market I'll be genuinely impressed. As it stands, I don't think we can tell the difference between skill and surfing a wave.

I think the points are firstly that if you are making 26% pa then at some point you become the victim of your own success, by definition your portfolio gets larger and more difficult to manage as time goes by. If PhilH keeps going the way he is then he won't be in modest amounts for too much longer. Unless I suppose he starts spending the money, or giving it away - I'm happy to provide bank details for donations : )

Secondly there are many cases of funds and investors returning exceptional gains over three to five years periods. Doing it over a 20 year period is another matter.

I have to add that there is a general historical theme that when people start saying "I've identified a fool proof method of successful investing" or "its different this time" or "there is a way of always beating the market" things have a habit of going spectacularly wrong shortly afterwards. I think its best to maintain a sceptical perspective on one's own abilities and what can realistically be achieved.

On your last point about WB what he does do is operate on the basis of valuation which is a proxy for market timing, if it is too pricy he stands back and waits for value to reassert itself.

Portfolio size here is irrelevant, even if Phil has £1m and achieves 26% compound for 20 years he has £100m, not really a problem when half his stocks are £1bn + companies. Lynch had the problem because of the client money poring in, Buffett has a massive insurance float, their issues were not because of compounding an initial stake.

Agreed. Unless specializing in microcaps or going for extreme concentration, the private investor should have no limitations from portfolio size until he's running several million. Even then, it should only be an issue if dealing in illiquid small caps.

As there are an awful lot of people here who seem to operate with a minimum market cap limit, I don't see why portfolio size would be an issue.

When you are buying international stocks traded in different currencies if the pound declines against those currencies then you make a gain without the share price doing anything in its own currency. The gain is real but not repeatable unless the pound continues to fall, which it may do if Brexit goes really badly, but not indefinitely.

However, personally I would want to strip out the FX effect on the growth of each holding in the portfolio to get a better view of the what is contributing to the growth. I would want to know to what extent I had picked companies that have done well in constant currency to measure how well I was stock picking. To me the FX gain is more like a geographical asset allocation gain which may also be down to skill but I would want to look at this a separate issue.

Comparing domestic portfolio folio performance or benchmarks against international has some validity as the gains in each case are real but it’s not really clear where the relatively better or worse performance is coming from and how sustainable that may be.

Yes. However, that is not the share price and they will normally report their results with both the headline numbers and the numbers at constant currency. By making the revenues etc at constant currency visible the market can factor in how well they are really doing rather taking the tail or headwinds of FX into account.

The point is about visibility and relevant benchmarking. You wouldn’t benchmark a fund manager investing in small cap European stocks against one investing in the whole of the US market because it is not a good comparator. You would benchmark against other European small cap managers and a European small cap index.

Yes I agree with your first point if there is an anomaly, maybe that's why Stockopedia does not work so well in the US markets. But I don't think these are necessarily mispriced, in fact many investors will think they are overpriced. I agree about tipsters, the prices are often marked up before the market opens, seen that with IC tips. I also agree that momentum based strategy will not work in a bear market that's why the likes of Minervini will be out or shorting the markets. Why do they write about their trades because it probably supports the shares and of course they are ahead of the information, they will buy and sell before anyone else knows. As for growth making it less manageable then that maybe the in case for some, for me it's not a problem, in fact at times I could do with more funds, I buy UK and European shares and a few US, most European and US shares don't have a liquidity problems and I can easily double my stake in each. After the next crash I will probably buy more US shares. I don't have Bethshire Hathaway's figures for last year but I have the last 3, 5 and 10 years, which were 35%, 80% and 117%, the S&P500 produced 33%, 83% and 117%. I can see why he advises buying index trackers. Yes I agree about bear markets, difficult to make money unless you short the market. I will probably sell most of mine apart from the income ones, some defensives and do some index shorts. In a bear market it's not about making money it's about not losing, I would like to be mostly cash so I can re-enter when the markets start to pick up. I'm already part of the way there.